Monday, May 1, 2017

93 words, most of them wrong

"Tucked inside a nearly 600-page legislative proposal to overhaul U.S. financial regulations are 93 words that could provide a windfall for bank investors seeking heftier dividends and share buybacks."

"Bank analysts at Barclays BCS -6.08% PLC estimate $236 billion in capital is tied up in operational risk at the four biggest U.S. banks alone"

"Bankers ... want to free up capital that could be returned to shareholders or used for more lending."

"Mr. Dimon added that U.S. banks now hold about $200 billion in capital against operational risk."

(I made it easier with italics, all mine.)

Windfall? When a company pays out dividends, the stock price goes down exactly by the amount of the dividend payment.

Capital is not tied up. Capital is a source of funds, not a use of funds. Capital is equity investment in the bank -- people give the bank money, in return for a stream of dividends. Capital is not reserves -- cash lying around the vault.

Capital is already used for lending! Banks get money from equity holders, bond holders, and deposits, and lend it out. Capital requirements are about the ratio of sources of money. (At best, lower capital requirements would allow banks to borrow more money without issuing more equity to lend. If they wanted to.) Capital is not reserves.

No bank "holds" capital, and I hope Mr. Dimon didn't actually say that, as much as he would like lower capital requirements. Capital is not "held" like reserves.

This article does reflect nicely the total level of confusion in the debate about banking regulations. Colleagues contemplating clever complex schemes, take note.

29 comments:

Bank reformers have a theory that banks pay out dividends, despite low levels of capital, because they want to benefit from implicit taxpayer guarantees. If that were true, share prices would drop by *less* than the dividend payment, as the implicit guarantee increases in value. Bank reformers are trying to prevent this enrichment of shareholders at the expense of the taxpayer, among other problems.

This is pretty common terminology in the industry, even it seems at odd with the accounting.

A bank's various activities create regulatory capital requirements. For internal accounting purposes, a bank will allocate its actual capital to different business areas to set against these requirements. For a business area within the bank to be able to make a loan, it has to have a sufficient allocation of capital to meet the regulatory requirement. Hence, if there are other activities creating a high regulatory requirement (and therefore reducing the headroom), people might talk about capital being tied up and not available for lending.

That would probably be more precise, but perhaps more of a mouthful - people probably wouldn't bother saying that. They don't, of course, mean the capital is available to lend out; they mean it's available for the lending business area.

Every source of capital is someone else’s use, and everyone’s source has a corresponding use. I show the accounts for an individual, but it is clear that the accounting rules mean that both sides of the accounts stretch into the larger economy. In this sense the money flow framework is the natural macroeconomic counterpart of the microeconomic settlement constraint.Leverage is inversely related to total assets. best

Yes, capital is a form of funding. And it is not “held” in the sense that it is not held as an asset. The terminology is not exactly pristine.

However, the question of “how much capital to hold” is indeed very common terminology in the industry. That's not the best excuse, but I suppose one might make more sense of it in the abstract (but balanced) context of “holding” both assets and liabilities (and equity) as balance sheet items.

(This can all be quite confusing for those trying to learn how banking works, similar to the case of the various contexts for the use of the term “reserves” (reserves held in the asset of "high powered money"; loan loss reserves “held” as liabilities; etc.))

Where I disagree in a more substantive way:

If $ 236 billion is the correct number, then that number is required as equity funding and is allocated to support operational risk. If some regulator were to deem this capital support is no longer required, and if bank management agreed with that, then the bank no longer needs that amount of equity funding (other things equal). The salient point here is that equity funding is the most expensive form of funding – the highest cost of capital in the much broader sense of that word capital (i.e. all funding forms). So equity funding can be replaced with cheaper funding. The point is not that the stock price goes down after a dividend is paid – it is that the bank is now more highly leveraged (as permitted) to allow for higher margins in respect of the future return on capital. Similarly, even though the book and market values of total equity will decline after a stock buyback, the bank will be in a higher leveraged position for future increased return on capital, other things equal. “Windfall” is probably a poor use of that word, but in fact the expected ROE or at least the expected earnings per share will be higher after such dividends or buybacks, other things equal, and it is because operational risk capital has been jettisoned from its prior use in this example.

And it is absolutely correct that such freed up capital could be “used for more lending” in this context. Although capital is a source of funding on a 1:1 basis, it is also a source of risk support, which in the case of credit risk might be something more like 10:1 (or whatever) for loan assets supported by a given quantity of capital in the context of risk, along with other forms of funding. Capital is a source of nominal funding, but it is also a source of potential balance sheet expansion beyond that nominal funding source. It is in the associated leveraged expansion of assets that “used for more lending” is perfectly appropriate. It’s just that more lending can’t occur without the support of additional non-capital funding in order to fully fund the nominal asset expansion.

In a similar vein, “tied up capital” is also very common industry parlance. And its not so bad. The idea is that capital must be allocated to various risks, and the quantity of capital is limited. Whether operational risk, credit risk, market risk, whatever risk … it is the allocation of capital to these various business risks that “ties it up” once that allocation has been made. If that capital can be freed from that business requirement, then it can be used to support other risks, or paid away in share buybacks or special dividends.

Can’t resist adding to my comment, because the use of the language becomes more interesting the more I think about it.

I think it helps to frame language use in capital management by considering the internal organization of banks in the management of liquidity and capital. These essential banking functions use language that is sometimes distinct and sometimes intersecting.

The language you are implicitly comfortable with through this post is the language of liquidity management. That is the function that is arguably the most visible to outside interpreters of banking – including professional economists. Although I assure you it is very complex when viewed from the perspective of internal organization. Capital as you say is a source of funds. This is associated with the commonly understood perspective of basic flow of funds accounting, which reflects at the core the function of liquidity management. And this is quite visible to the outside world through a simple categorization of funding types in conventional financial accounting statements such as balance sheet and sources/uses of funds. I think the potential abuses of language that you cite are in the context that they don’t make much sense when viewed from that perspective of funds flow and liquidity management.

What is less visible to the outside world is the nature of the internal accounting systems that are used by banking in the allocation of capital to risk. That is the essential role capital, making it different from other sources of funding. These capital allocation systems intersect with flow of funds accounting in interesting ways.

One of the ingredients of such an internal capital allocation system is the identification of excess capital. This is a clear delineation of capital that is on the balance sheet but that has not yet been allocated in the sense of its use in backing risk and acting as insurance against losses from existing businesses. The presence of excess capital is linked through internal funds transfer systems to specific risk free (or close to risk free), liquid assets such as treasury bills for example (albeit even there with very minor interest risk perhaps). The loss insurance purpose is not a requirement for those assets, so the connection is consistent with the notion of capital excess. The rest of the capital – that which is not excess (which is obviously most of it in the normal case) – is allocated to risk taking businesses. This includes capital for credit risk, market risk, operational risk, etc. etc. Those allocations to specific risk areas include a similar type of liquidity connection as is the case for excess capital, where the loss insurance function exists jointly with the funding function.

I think the use of the word “holding” for starters becomes a little more understandable if one thinks of the allocated capital as being compartmentalized into specific risk support categories – for different businesses and for different types of risk. That capital is “held” for those uses in the sense of not being available as excess capital and therefore not being available for new purposes. It is being used and therefore can’t be released or allocated to new purposes. Maybe think of it as a realized “hold back” of the large proportion of total existing capital, not available for other purposes, compared to a portion of total capital that is currently excess and more freely available either to be used for new business risk taking or to be distributed to shareholders.

Perhaps that makes the language of “held”, “used”, and “tied up” a bit more understandable. This is the language that is commonly used in the context of capital allocation systems, where capital is considered for its essential purpose as protection against losses, that being the critical refinement on its more basic characteristic as a source of funding - a source of funding that is good only so long as those losses are not being experienced.

"No bank "holds" capital, and I hope Mr. Dimon didn't actually say that, as much as he would like lower capital requirements. Capital is not "held" like reserves."

I assure that he uses this kind of language frequently - in the context of all of the risks that capital supports. And I further assure you that he knows the difference between the asset and liability sides of the balance sheet. And I am quite certain that he knows that capital does not reside on the asset side of the balance sheet.

Very simplified: loan loss reserves are essentially a segregation of what was previously equity capital in the estimate/expectation of future loan losses. It’s a conservative approach to accounting in that it’s a transitional step in declaring actual losses. The bank isn’t quite ready to throw in the towel on the related loan assets, but at the same time doesn’t want to overstate the effective level of equity capital. If an actual loss is taken, both the asset and the loan loss reserve are written down.

Assets are risk weighted for capital ratio and so doesnt reducing equity capital in that way result in taking the risk of loan loss into consideration twice over when calculating capital to risk weighted asset ratio.

Government eliminates regulation. Bank decides to swap equity capital for short term bank debt at the margin because it's legal now (so the equity buffer declines to 5% now vs 10% before of total capital). This swap can be thought of as a special dividend followed by short term borrowing @ LIBOR. Because the bank has an implicit government backstop and a default option, the sum of the dividend and equity is greater than the previous equity price.

That's what it means to have capital "tied up" in a regulation. If the regulation weren't there, the banks could replace equity with bank debt. Perhaps it would be more accurate to say that "equity" is tied up in the regulation instead of capital proper.

I really wonder if the result of deregulation would be a swap of debt for equity. We could also see banks simply return some capital to investors and reduce their holdings of assets that are assigned risk weights of zero by regulators. This increases the banks' total valuations because they can stop paying the convenience yield on assets that are more liquid than bank debt, and were held only to meet regulatory requirements. There definitely is the downside that with less holdings of excess reserves or other government debt, there is less self-insurance by banks and some degree of wealth transfer from taxpayers to bank shareholders.

"Capital is not tied up. Capital is a source of funds, not a use of funds. Capital is equity investment in the bank -- people give the bank money, in return for a stream of dividends. Capital is not reserves -- cash lying around the vault."

Capital is neither a source of funds nor a use of those funds - it is the funds themselves. Bank capital is any money the bank receives whether they borrow it, sell shares to obtain it, or retain a profit.

https://en.wikipedia.org/wiki/Tier_1_capital

"Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed RESERVES (or retained earnings), but may also include non-redeemable non-cumulative preferred stock."

A capital adequacy ratio (CAR) is the ratio of the bank's capital (monetary assets) to it's risk weighted assets (generally loans). The when sold or par value of debt and equity is used when calculating the CAR.

Where in that definition of capital is a reference to liabilaites. Or do you think it is reasonble to define capital without a reference to liabilaties. The wording on that Basel III document is unusual. The text book definition of capital is the result of summing the assets and subtracting the liabilaties..

Equity shares and debt are both liabilities of a bank (or any other corporation for that matter). If a bank wanted to go from publicly capitalized to privately held, it would need to retire it's outstanding publicly held debt and equity.

The problem with these definitions is that valuation on a bank's debt and equity is not identified - should a market based valuation be used or should a par / when sold valuation be used.

This becomes clearer when we look at the various regulatory ratios a bank must meet.

CAR = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets

For a bank to hit a prescribed CAR we use the market valuation of assets (Risk Weighted Assets) and we use the par / when sold value of debt and equity.

Obviously we can't use market valuation for both bank assets (denominator) and bank debt / equity (numerator). Doing so would make it impossible for a bank to hit a prescribed ratio.

Disclosed reserves and loan loss reserves are typically cash holdings of the bank ($1 of reserves = $1 of capital). Undisclosed reserves and revaluation reserves may be short term assets that are near cash equivalents (for instance short term Treasury Bills).

Notice that when the market value of a bank's assets fall, it's CAR can actually improve - which seems somewhat counterintuitive until you realize that the whole purpose of measuring CAR is to measure how much risk a bank is able to offload to it's investors.

For instance picture two banks:

Bank A sells $1 million in equity shares and makes $1 million in loans (CAR = 1)

There is a problem with defining capital that way and thus CAR in that way.If a Bank issues deposit interest to its deposit holders or deposits to its shareholders in dividends , then its liabilities go up , but this doesn't appear anywhere in CAR.

The CAR is all about the bank's assets. If you want to look at how a bank's liabilities are structured, you need to look at it's Leverage Ratio (LVR). See:

https://en.wikipedia.org/wiki/Basel_III

"Basel III introduced a minimum leverage ratio. This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items). The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.

In July 2013, the U.S. Federal Reserve announced that the minimum Basel III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks and 5% for their insured bank holding companies."

"Leverage Ratio (LVR) = Tier 1 Capital / Assets"

When calculating the leverage ratio, we use the market value of equity and other Tier 1 Capital and the when purchased value of assets. It is assumed that the when purchased value of assets should equal the par / when sold value of all liabilities (debt and equity).

And so we can back calculate a Debt (liability) to Equity (liability) ratio this way:

Debt to Equity Ratio (DER) = 1 / LVR - 1

Regarding deposits, they are a liability to a bank in a strict sense. Hence you would expect them to be expressed in the Leverage Ratio (not the CAR).

Even still:

1. A bank can suspend interest payments to savings / checking depositors at any time.

2. The only liability incurred by a bank with deposits is returning them to the depositor on a one for one basis. Savings / checking account holders are not entitled to any profits or interest payments from the bank.

Obviously, if a bank gets robbed either physically or electronically, then those deposit liabilities become an issue for the bank.

1. A deposit (savings / checking) is not a loan to a bank in any sense. Banks accept deposits as a caretaker action instead of a financing action.

2. Interest payments on savings / checking deposits are at the complete discretion of the bank - unlike borrowing from investors where the interest payments are legally binding as part of the loan agreement.

3. With a certificate of deposit (CD), a depositor accepts that in exchange for higher interest payments, his / her money is going to be tied up for a while - the deposits cease to exist as a liquid fund accessible to the depositor.

No, incorrect. What you are referring to here is the Leverage Ratio (Not Capital Ratio).

https://en.wikipedia.org/wiki/Basel_III

"Basel III introduced a minimum leverage ratio. This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items)."

Leverage Ratio (LVR) = Tier 1 Capital / Non-Risk Weighted Assets

You can calculate a bank's debt to equity ratio this way:

Debt / Equity (DE) = 1 / LVR - 1

And so if a bank has a leverage ratio of 8%, it's debt to equity ratio is:

A capital adequacy ratio measures the ratio of all the risk free assets that a bank holds (retained earnings, money from the sale of shares, money that is borrowed, reserves) vs. all the risk bearing assets that a bank holds.

A capital adequacy ratio is a ratio of the bank's assets. Hence the "when sold" value of bank equity is used when calculating that ratio (not the market value).

A leverage ratio is a ratio of the bank's liabilities. Tier 1 capital consists of equity, retained earnings, and reserves. Here the market value of equity is used. If a bank wants to buy back it's shares, it buys them back at the market value (not when sold value). The market value of equity is used because that is how the bank's equity liability is measured.

In the denominator, the total non-risk adjusted value of assets is used. This should be equivalent to the sum of the market value of a bank's equity plus the par value of a bank's debt. And so the debt to equity ratio can be teased out this way:

Debt / Equity = ( 1 / ( Equity / (Debt + Equity) ) - 1

Debt is always treated at it's par value - again that is how a bank's debt liability is measured. The bank (just like you or me) is on the hook for the full amount of it's debt even if that debt trades on the market at a discount to par.

A succinct statement of the bleeding obvious seems to have gone right over most people's heads if the comments on here are anything to go by. No amount of pedantry or self-justification can change the single basic fact: the WSJ article is bollocks, as John so clearly points out.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!